The FSA should join the roll of City failures

Yesterday, HBOS and Lloyds were locked in merger talks. Apparently they were "nudged" by Gordon Brown, the Financial Services Authority and the Treasury. These events followed rapidly after the collapse of Lehman Brothers.

At least we have reined back from the dangerous precedent of Fannie Mae and Freddie Mac, where the US government seemed to be developing a giant welfare state for bankers. But, nevertheless, there are growing calls for more regulation: is this the end of our liberal, capitalist financial system?

In fact, we already have an extensively regulated financial system. Freddie Mac and Fannie Mae had well over 200 regulators all to themselves.

In the UK, the FSA has frighteningly wide powers. Arguably, the very financial instruments that have caused recent problems - securitised mortgages - have been designed to avoid the inflexible regulation of the traditional banking sector. The more the regulators regulate, the more the whizz kids put their efforts into designing more complex products.

There are two further salutary lessons for those who believe that more regulation is the answer to our problems. As Eamonn Butler from the Adam Smith Institute has noted, US banks were forced by regulation to make loans to people who had poor repayment histories.

Also, when the dust has settled, we will probably come to the view that the underlying cause of the current crisis is that, as some of us warned, monetary policy was far too loose for far too long in both the US and the UK.

Low interest rates led to the underpricing of credit. This was also the cause of the boom that preceded the Great Depression. The US government overreacted with the introduction of draconian financial regulation then. Our government should avoid making that mistake today.

Markets may misallocate resources at times, but we should not think regulators can do better. The all-knowing, beneficent regulator is a creature of the imagination of social democrats.

We should begin by determining precisely what the limited objectives of financial regulation should be and develop institutions to achieve those objectives. Two aspects of the regulatory system introduced by Gordon Brown about 10 years ago need to be overhauled. Brown gave very general powers to the FSA to "promote public confidence in the financial system" and to "secure appropriate degrees of protection for consumers". This was a big mistake. The FSA has developed thousands of pages of regulations to try to achieve the unachievable, while missing the obvious.

Secondly, Brown simultaneously managed to put all the regulators under one roof, while leaving gaps between those authorities responsible for managing the most acute forms of crisis: quite an achievement! We saw the effects of this in the Northern Rock affair.

There are some very specific problems that we know can arise and regulation should focus on those. By ensuring this is done, it is possible for a future government with strong beliefs in free markets - if there is to be one - to respond effectively to the crisis and to reduce financial regulation.

The Bank of England should be the lender of last resort, with no ambiguity. And it should be the banking system's regulator again. The Bank should have its capital provided by the private sector - as it did from 1694 to 1946.

Any bank that wished to make use of lender of last resort facilities should submit to the regulation of the Bank of England regarding liquidity and capital requirements. This would be a simple regulatory response to a well-defined problem. It is a liberal response too. Banks could choose to remain outside this system but they would have to make it clear to their customers that they would never receive any support from the Bank of England if there were problems.

Much of the detailed regulation currently carried out by the FSA could be undertaken by stock exchanges. Competition between exchanges for business is fierce and the market already is divided between those exchanges that compete on the tightness of their regulation and exchanges, such as the Alternative Investment Market, where regulation is looser.

Instead of focusing on the detail, the financial regulator should then concentrate on ensuring that there is an orderly winding up of institutions that fail and, if necessary, oiling the wheels to prevent failure. This seems to be happening with Lehman Brothers in the US, and with HBOS in the UK. Often our legal systems cannot cope with the complex web of transactions left behind when financial institutions fail.

It is not for the government to provide guarantees - as the US government did in the case of Bear Stearns, Fannie Mae and Freddie Mac. Rather, the regulator should make sure that promises are honoured, insofar as they can be, and that an institution is wound up with as little disruption as possible. In any winding up, the customers and counterparties should come first: if there is nothing left for the shareholders and bondholders - too bad.

To sum up, Gordon Brown created a regulator that has a giant footprint on the financial system. Meanwhile, financial institutions try to develop complex instruments to wriggle out from under the boot. The FSA cannot do its job properly because it has an impossible job. We need regulators with some specific roles to step in to deal with problems that we all know we will get from time to time in financial systems. It is time to break up the FSA.

Philip Booth is Editorial and Programme Director of the Institute of Economic Affairs